June 22, 2011

Why Won't the SEC Investigate Motorola … Again?

The following is more (see my earlier post) from PCAOB chair Jim Doty's June 2ndspeech, describing an auditor's failure to correct an accounting misstatement that was "galling in its simplicity":

"PCAOB inspectors found at one large firm that an engagement team was aware that a significant contract was not signed until the early hours of the fourth quarter. Nevertheless, the audit partner allowed the company to book the transaction in the third quarter, which allowed the company to meet its earnings target. Although the firm discussed the timing of the transaction with the customer, it failed to obtain persuasive evidence of an arrangement for revenue recognition purposes in the third quarter. The company had been an audit client of the firm for close to 50 years." [Italics supplied]

Obviously, Doty used this case to illustrate the independence problems inherent in excessively long auditor tenure (in this case, nearly 50 years). And, consistent with long-standing, albeit questionable, PCAOB policies, Doty would not name names. But, once Bloomberg columnist Jonathan Weil plucked the parties' identities and some other sordid details from court records, this case appears to have left egg on the face of the SEC as well:

[KPMG's and] Motorola's identity [now known as Motorola Solutions Inc.] was disclosed in public records last month as part of a class-action shareholder lawsuit against the company in a federal district court in Chicago. The plaintiffs in the case … filed a transcript of a September 2010 deposition of a KPMG auditor, David Pratt … "

Jon goes on to report that the size of the alleged deception was just as galling as the simplicity decried by Doty. The plaintiffs are alleging that Motorola inappropriately recognized $275 million of earnings during the 2006 third quarter, or 28% of net income.

SEC MIA?

Why has the SEC apparently not followed up on the PCAOB's findings? For one thing, the PCAOB inspection report provides highly credible evidence of a very large accounting misstatement made by a high-profile registrant, and with the apparent complicity of its Big Four auditor. It doesn't necessarily mean that the PCAOB is correct in its allegations, but someone should called to account by the SEC: if not Motorola and/or KPMG, then the PCAOB for a faulty inspection report.

For another thing, this case is certainly not an isolated instance for KPMG, or for that matter, Motorola. In May 2007 the SEC found that Motorola knowingly helped Adelphia Communications Corp. cook its books way back in 2000 and 2001. The 'assistance' Motorola provided to its valued customer took the form of a sham "marketing support" transaction that amounted to nothing more than a roundtrip of cash. In settlement of the SEC's proceedings against it, Motorola agreed to pay a $25 million fine and consented (without admitting or denying guilt, of course) to the entry of a cease and desist order against cooking its own books -- or anyone else's.*

Technically, I suppose, Motorola can't be accused of violating the SEC's C&D order when it allegedly cooked its own books in 2006, since the C&D order wasn't issued until 2007. But, the C&D certainly does gum up the works. With hindsight, at least, the sanctions already imposed by the SEC on Motorola would have been more severe if the SEC had known about the 2006 violations, and which the PCAOB discovered soon afterwards. In particular, no individuals at Motorola were sanctioned. One might also ask whether the 2006 alleged violations could have been prevented by the SEC, if they had not taken so long to settle the earlier ones?

And, what should become of Motorola's long-standing auditors, KPMG? They apparently knew of Motorola's questionable accounting in 2006, because they consented to it. But, inquiring minds now want to know if KPMG had also been aware of (and perhaps complicit in) the sham transaction with Adelphia. But, even if their hands are clean on the Adelphia matter, how is KPMG going to defend its issuance of a clean attestation report covering Motorola's internal controls over financial reporting?

When I was at the SEC, way back in 1992-93, it seemed that the Enforcement staff would grab all of the low hanging fruit they could get their hands on. Most the time, the open and shut cases involved small issuers and small auditing firms. But, I was never under the impression that the largest issuers and their auditors were out of bounds. As the SEC's decision to not seek sanctions against Motorola and KPMG defies a reasoned or principled explanation, it looks like either politics, indifference or incompetence are to blame.

What This Case Says about Auditor Term Limits

I had originally reported on Jim Doty's speech out of my interest in promoting enhanced audit reliability through mandatory audit firm term limits. The clear implication of Doty's remarks is that KPMG's decades-long relationship with Motorola eventually became more obstructive than protective. I'll close this post with the following observations and conjectures:

Even apart from the effect on its brand and integrity, the actual direct costs and potential losses to Motorola from this litigation probably wiped out any of the 'audit efficiency savings' from its half-century monogamous relationship with KPMG. I see no legitimate justification for Motorola to retain the same auditor for that long.

Would anyone be surprised if the allegedly improper accounting were also linked to questionable bonus payments?

What is currently on the minds of the members of Motorola's audit committee? I would not be surprised if the committee has never even addressed whether KPMG bore some responsibility by failing to detect the existence of the sham transaction with Adelphia.

Given the PCAOB's latest findings, the litigation and the latest publicity, does the audit committee still support retaining KPMG? If so, what are they thinking?

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*The technical prohibitions, known as 'books and records provisions' are to be found in Sections 13(a) and 13(b)(2)(A) of the Securities Exchange Act of 1934 and SEC Rules 12b-20, 13a-1, and 13a-13 t him hereunder.

Comments

This is meant to address mandatory rotation and the posts “Audit Firm Term Limits: Nothing Else Left to Try” (June 15) and “Why Won't the SEC Investigate Motorola … Again?” (June 22).

I agree with “Bitter Audit Partner”, who stated “Rotation is not the answer, and not really the problem.”

Moreover, I read about KPMG with interest, although it’s been nearly six years since I left the firm. That time allows me to reveal that the events described in your post on IFRS in September 2009 occurred at KPMG.

In my short time there, the duration of the engagement relationship never mattered. What mattered was not displeasing the client, it was the principal elementof “professionalism”.

In the discussion detailed in the link above with the (now former) partner, I was lectured “if there’s no client, there’s no business”. Big firms don’t care if it’s a five year or fifty year relationship, they care that it’s an ongoing relationship.

The problem isn’t unlimited tenure; it’s that management hires and fires the audit firm (basically at will, with disclosure). When foxes hire and can fire the hound that guards the henhouse some chickens die.

Rotation that retains the present system of management retention of the auditor will ironically intensify this effect, because the costs of client acceptance will need to be amortized over a fixed period of time. Audit efficiency and effectiveness will decrease with every rotation as the new firm “ramps up” its specific knowledge of the client.

To really want to fix situations like the one at Motorola, you need remove management’s power over the auditor. I prefer the Board retain the auditor, because they are supposed to be acting in the interest of the investors anyway. This is the very reason that the IIA insists that internal audit report to the BOD. Or maybe there’s a committee of shareholders-just not management.

Of course there’s other problems, the insufficient alternatives that exist with only four firms at the top industry segments. It won't change because, S-Ox made formidable barriers to entry to the “Big” segment insurmountable. No Congress is going to repeal S-Ox even though it’s a rain dance, because they fear blame for the next scandalous audit failure, when, not if, it occurs (no matter what laws are on the books). Also, there’s just too much money to be spent on lobbying and campaigning by the constituencies that profit handsomely from S-Ox compliance services.

I am not sure if this should really surprise anyone. The SEC has so much on it's plate these days that I'm not sure that can actually investigate everything. Seems they are taking a closer look at the hedge funds (thanks to Madoff) and not investigating many corporate clients.